How to Zig When U.S. Stocks Zag
When storm clouds brew over U.S. stocks, investors often seek shelter overseas. Foreign firms account for more than half of the world's stock market capitalization, and when U.S. stocks have zigged, foreign ones historically have zagged. Or they haven't zigged as much.
But globalization has brought the performance of the two asset classes closer together. At the start of this decade, there was only a 32 percent correlation between the movements in foreign and U.S. stocks, according to Merrill Lynch. Today, it's around 96 percent. "It's wrong to think that owning foreign stocks will mean your portfolio will move in the opposite direction of the U.S. market," says Gregg Wolper, senior fund analyst for Morningstar.
But, with some work, foreign stocks can help diversify your portfolio.
If you're thinking of moving money from U.S. blue-chip stock funds to foreign blue-chip funds that invest in western Europe, don't expect your portfolio to suddenly become less risky. For diversification, "there's no real difference between buying British Petroleum or Exxon, or between Pfizer and GlaxoSmithKline," says Nicholas Smithie, vice president and portfolio manager for MFS Investment Management.
Hot funds. So while large-cap foreign funds can be the core of your foreign holdings, you'll have to search elsewhere for real diversification. A small weighting, say 5 to 10 percent, of emerging-markets stock funds--which invest in companies based in growing economies like Brazil and South Korea--would have increased the performance of your portfolio over the past five years without adding much to volatility.
But tread carefully. Emerging markets have already soared more than 40 percent a year for the past three years. And by themselves, emerging-markets stocks are volatile. Indeed, the worst three-month loss for these stocks was a 32 percent drop during the Asian currency crisis of the late 1990s. The worst three-month loss for blue-chip foreign funds was a 19.8 percent decline in 2002.
Many Latin American and Asian companies are tied to the production of industrial materials that fuel the global industrial boom. The commodities markets, led by oil, gold, and copper, have been on fire. But if the global boom eventually busts, demand for commodities will sink and, with it, the emerging markets.
Other ways to diversify overseas: Add foreign small-cap stock funds, which aren't as volatile as emerging-markets shares. And for investors who don't want to juggle different types of foreign holdings, a few all-in-one international funds provide instant diversification. These include the MFS International Diversification Fund and Laudus International MarketMasters. Both invest in developed and emerging markets, in small and large stocks.
"You have to remember, you're still investing in equities, and equities come with risks," says Jeff Mortimer, head of equity portfolio management at Charles Schwab Investment Management. But to the extent you can lessen those risks through diversification, foreign stocks may be a viable option.
This story appears in the May 8, 2006 print edition of U.S. News & World Report.
advertisement
